With this week's cut, Australia's cash rate has fallen to its lowest level in decades, possibly longer. Along with the usual roulette as to whether the banks will pass the full benefit on to customers, there is a growing chorus of voices criticising the decision; saying that monetary policy is now powerless, or that the Reserve Bank of Australia should hold its firepower in reserve for a real crisis. While there are certainly real concerns over the level of interest rates, and the conduct of monetary and fiscal policy, it's important to understand what the rate cut really means and what it doesn't mean. First, we need to dispense with the myth that low interest rates mean loose monetary policy (denoting the encouragement of an increase in inflation and nominal economic growth). This is not a new fallacy. Milton Friedman and others pointed out the flaws in this thinking decades ago; but its persistence clouds understanding over the effectiveness, and role, of monetary policy. On the contrary, the way you determine whether monetary policy is accommodating or not is to look at the level of inflation and growth. And right now, both figures are well below where they should be. Inflation in particular has been at or below the bottom of RBA's target level (2 per cent to 3 per cent) for a number of years. This is important because it is one reason why the argument that the RBA is powerless is incorrect. A more likely explanation is not that the RBA has been too accommodating (and has been ineffective), but that the RBA has actually been too timid. After all, inflation has been at or below target for the last three years, yet interest rates remained unchanged. Complaining that inflation hasn't improved during that time is a bit like Ned Flanders' parents in The Simpsons: "we've tried nothing and we're all out of ideas." But won't that mean we hit 0 per cent interest rates? Yes and that is neither a disaster, nor the end of the RBA's tool chest. This is the other problem with the idea that monetary policy is impotent: it relies on the assumption that tweaking the interest rate and hoping for the best is all the RBA can do. Implicitly it assumes, the RBA cannot generate inflation regardless of how hard they try. If we have really reached a point where a central bank cannot generate inflation no matter what they do, then we truly are beyond the looking glass. But that seems remarkably improbable: if the RBA jammed huge amounts of money into the economy, inflation would take off as it has in Zimbabwe and Venezuela. No-one is suggesting that hyperinflation is a good idea, only that if the RBA wanted to boost inflation they could. That means that low inflation is implicitly or explicitly a choice. In many ways, this is an understandable mistake: for most of the 20th Century the problem was far too much inflation, not too little. Central bankers remain hesitant to unleash the inflation genie, for fear they could not get it back under control. We don't want a repeat of the stagflation of the 1970s, but nor do we want to follow Japan into decades of dead deflation. Low interest rates, low inflation and low growth is not a good place to be. And here is where criticisms that the RBA should keep its powder dry in case we face a crisis fall flat. Even if you ignore other tools the RBA can employ once interest rates reach 0 per cent, we actually need to take the handbrake off economic growth so interest rates will rise and the RBA will have more ability to use its traditional tools in the event of a crash. The RBA needs to do its bit to keep nominal growth high. The government needs to step up as well. But this does not mean (as some would like to think) the government should run big, stimulatory deficits. The inaction by the government has not been deficit spending of which there has been plenty but the complete absence of microeconomic reforms that would generate real economic growth. On the contrary, western governments have passed tens of thousands of pages of new laws, adding a huge compliance burden, and significant costs on business, in the mistaken assumption there is no growth cost to more regulation. In many ways, it is remarkable that we who basically led the world in turning ourselves into an open, dynamic economy have seemingly forgotten the lessons we so painfully learnt in the 1970s. It is even more surprising given the tremendous success we have seen in the period since. If we want economic growth, we need to encourage business investment. We need to generate more competition and we need to unlock the power of the market. For two decades in the 80s and 90s we deregulated, passing reforms that increased competition and the power of the market and the result was sustained economic growth. But for the past decade we have tried to shackle business and markets in the name of equality, and the result has been that growth has slowed down. This pattern has played out across many western nations, all of whom are now struggling with similar problems of low growth and low interest rates. There is little doubt this has also contributed to the problem of slow wage growth. This is the real limit of monetary policy: its influence is primarily on the nominal economy and will only keep slow economic growth at bay in the short term. It is not a replacement for good government.

Dispensing with the myths around low interest rates

With this week's cut, Australia's cash rate has fallen to its lowest level in decades, possibly longer. Along with the usual roulette as to whether the banks will pass the full benefit on to customers, there is a growing chorus of voices criticising the decision; saying that monetary policy is now powerless, or that the Reserve Bank of Australia should hold its firepower in reserve for a real crisis.

While there are certainly real concerns over the level of interest rates, and the conduct of monetary and fiscal policy, it's important to understand what the rate cut really means and what it doesn't mean.

If we want economic growth, we need to encourage business investment. We need to generate more competition and unlock the power of the market. Picture: Dominic Lorrimer

First, we need to dispense with the myth that low interest rates mean loose monetary policy (denoting the encouragement of an increase in inflation and nominal economic growth).

This is not a new fallacy. Milton Friedman and others pointed out the flaws in this thinking decades ago; but its persistence clouds understanding over the effectiveness, and role, of monetary policy.

On the contrary, the way you determine whether monetary policy is accommodating or not is to look at the level of inflation and growth.

And right now, both figures are well below where they should be.

Inflation in particular has been at or below the bottom of RBA's target level (2 per cent to 3 per cent) for a number of years. This is important because it is one reason why the argument that the RBA is powerless is incorrect.

A more likely explanation is not that the RBA has been too accommodating (and has been ineffective), but that the RBA has actually been too timid.

After all, inflation has been at or below target for the last three years, yet interest rates remained unchanged. Complaining that inflation hasn't improved during that time is a bit like Ned Flanders' parents in The Simpsons: "we've tried nothing and we're all out of ideas."

But won't that mean we hit 0 per cent interest rates? Yes and that is neither a disaster, nor the end of the RBA's tool chest.

This is the other problem with the idea that monetary policy is impotent: it relies on the assumption that tweaking the interest rate and hoping for the best is all the RBA can do.

Implicitly it assumes, the RBA cannot generate inflation regardless of how hard they try.

The RBA, led by Governor Dr Philip Lowe, needs to do its bit to keep nominal growth high. Picture: AAP

If we have really reached a point where a central bank cannot generate inflation no matter what they do, then we truly are beyond the looking glass.

But that seems remarkably improbable: if the RBA jammed huge amounts of money into the economy, inflation would take off as it has in Zimbabwe and Venezuela.

No-one is suggesting that hyperinflation is a good idea, only that if the RBA wanted to boost inflation they could. That means that low inflation is implicitly or explicitly a choice.

In many ways, this is an understandable mistake: for most of the 20th Century the problem was far too much inflation, not too little.

Central bankers remain hesitant to unleash the inflation genie, for fear they could not get it back under control.

We don't want a repeat of the stagflation of the 1970s, but nor do we want to follow Japan into decades of dead deflation. Low interest rates, low inflation and low growth is not a good place to be.

And here is where criticisms that the RBA should keep its powder dry in case we face a crisis fall flat.

Even if you ignore other tools the RBA can employ once interest rates reach 0 per cent, we actually need to take the handbrake off economic growth so interest rates will rise and the RBA will have more ability to use its traditional tools in the event of a crash.

The RBA needs to do its bit to keep nominal growth high. The government needs to step up as well.

But this does not mean (as some would like to think) the government should run big, stimulatory deficits.

The inaction by the government has not been deficit spending of which there has been plenty but the complete absence of microeconomic reforms that would generate real economic growth.

On the contrary, western governments have passed tens of thousands of pages of new laws, adding a huge compliance burden, and significant costs on business, in the mistaken assumption there is no growth cost to more regulation.

In many ways, it is remarkable that we who basically led the world in turning ourselves into an open, dynamic economy have seemingly forgotten the lessons we so painfully learnt in the 1970s.

It is even more surprising given the tremendous success we have seen in the period since.

If we want economic growth, we need to encourage business investment. We need to generate more competition and we need to unlock the power of the market.

For two decades in the 80s and 90s we deregulated, passing reforms that increased competition and the power of the market and the result was sustained economic growth.

But for the past decade we have tried to shackle business and markets in the name of equality, and the result has been that growth has slowed down.

This pattern has played out across many western nations, all of whom are now struggling with similar problems of low growth and low interest rates. There is little doubt this has also contributed to the problem of slow wage growth.

This is the real limit of monetary policy: its influence is primarily on the nominal economy and will only keep slow economic growth at bay in the short term. It is not a replacement for good government.

Simon Cowan is Research Director at the Centre for Independent Studies.